Michael Lewis’s highly readable account of the collapse of the US sub-prime mortgage market and the worldwide financial crisis it triggered focuses on a small number of characters. People with iconoclastic views determined not to be constrained by the old conventional rules. People who created new financial investments. People who put money into places their investors did not really understand on a good day and did not even know what had been done with their money on a bad day. People who made huge profits as others suffered.

But these people are not the villains – they are the heroes of Lewis’ book. These are the people who saw the problems in the sub-prime market and what really lay behind the supposed AAA ratings. They are the ones who understood what was really going on and who, if the rest of the world has listened to them sooner, would have been the saviours who had rescued the financial markets before they inflicted calamities on us all.

Although Michael Lewis does not say so himself, the similarity in behaviours and characters between those who got the sub-prime market horribly wrong and those who called it just right is striking. How to learn from all this when those who were right and those who were wrong turned up to be largely indistinguishable, save that hindsight justifies only one of those groups?

That could make for a rather depressing read amongst all the entertaining narrative. However, in his interview to go with the book (and included in some versions of it), Michael Lewis draws one main regulatory lesson and it is one that is being applied in the UK. It is to split off speculative investments from retail banking, or casino banking from boring banking if you will.

The book itself is a self-consciously narrow take on the financial disaster, looking at the traders involve in the sub-prime markets with the range of other markets and institutions, not to mention other countries, getting only limited walk-on parts.

It is therefore probably not the only book you might want to read about the financial crash, but it should certainly be one of them – especially as Lewis not only dishes out criticism widely but also makes an effort to explain why so many people turned out to have acted in ways that seemed so dumb.

8 Comments

Surely, Mark, this is a characteristic of gambling. You can inform yourself of some of the issues, facts and opinions around whatever it is you are gambling on, but you will never encompass everything. If your mores forbids gambling entirely, then it is very difficult for you to live in a real life situation, but on the other hand, if you are an addict, or a high roller determined to take huge risks, then it is not surprising you (and anyone else with money or interests in your “investments”) will get burnt. I am sure the maths of this issue is fascinating, and as you have read the book, perhaps you can let us know how much maths there is in it?

We are the heroes, and all our European colleagues. The Americans are the villains.

With the internationalization of financial markets, the Americans realized that much more could be gained by exporting pain compared to by the hard work needed to create value and import profit. So they created some pain in the form of sub-prime mortgages, created complex financial instruments by mixing the worthless future cashflows with valued things, and sold them to an unsuspecting world.

When the financial world worked out what had happened they looked around for a way to get their money back. The Americans duly obliged, by getting their ratings agencies to downgrade European sovereign debt. This meant that everyone who had taken a hit on the sub-prime market could recoup their losses by charging unsuspecting European countries huge interest on their debts.

So, we are the heroes, and all our European friends, such as the Greek people. The Americans are the villains. Some people think the City of London took part in the scam as well. Of course the reality is much more complex than this simple fairy tale, or is it?

I found Gillian Tett’s book to be a far better explanation of what happened. The one point that is missing is how “herd behaviour within the financial sector actually meant that no one was prepared to listen to the naysayers, who could be dismissed since they just a minority voice spoiling the fun for everyone.

When those designing asset backed securities just used the wrong default correlation figures and questionable models, the investment bankers concerned didn’t shout too much becuase of the extra fees that they would earn in selling the repackaged assets, neither did the rating agencies who profited from providing credit ratings, or the auditors who received fees from signing off the accounts and doing accounting work on the repackaged assets, nor the lawyers who received fees from doing all the legal documentation, nor the investment managers who earned non performance related fees from telling their clients to invest asset backed securities and the banks which issued them, nor the regulators who were rewarded for taking a deregulatory approach and wanted jobs back in sector after they had completed their stint, nor the politicians who profited from extra tax revenues while the bubble was being blown up.

Splitting off the investment banks will in itself not be enough should the financial sector herd start to rumble again. You already have the likes of Mr Diamond saying that the Vickers proposals will put up the cost of retail banking as he will need to get a higher return to compensate for that which is lost in transferring capital to the retail operations – and the markets are now pushing him to go for a higher returns (and risks) so as to justify his salary package. Mark my words – money will be very easily cycled into riskier activities if that is the flavour of month in the financial sector.

Other things we will need is to develop a real contrarian attitude among our regulators (not much chance of that with the current govt I’m afraid) and also a proper statregy to get the UK economy away from its overdependence on the financial sector (similar). We need a menatility where finance is seen as the servant rather the master.

Tim: there’s not much maths in the book, but I think it gives a pretty good sense of some of the key concepts – such as the way that a small sum wagered on a cataclysmic event happening brings enormous rewards if the bet comes off. But the fact that the event appears so very unlikely explains why so many people are willing to be on the other side of the bet. In fact one of the best bits for me was where the book explained quite how so many ended up thinking that US house prices would never fall across the whole country at the same time. From the outside that seemed a daft assumption for anyone to ever have made. After reading the book it still seems pretty daft… but at least I’ve got a better understanding of why so many people made that mistake.

If you’ve got 20 minutes to spare then you might find it interesting to watch this video of Michael Burry (heavily featured in The Big Short) who gave this commencement speech at UCLA just a few days ago.

It’s interesting for his commentary on Europe : “When the entitled elect themselves, the party accelerates and the brutal hangover is inevitable”.

One comment I found interesting in the book was that the more irresponsible attitudes to investing stemed from the time in th 1970s or 1980s when Wall St. firms went from being partnerships to being plcs. As partners the traders and managers had a closer relationship with their investors and those they invested in. In plcs, they were detached from the owners – the shareholders – and as volumes of trades went up from the investors and those invested in too.
This led to the 1990s and 2000s culture where greater risks were taken and more complex investment vehicles were invented, while many of the managers and traders were able to collect large rewards, even from failing and collapsing firms. (Though probably not as large as the figures suggest, if the bonusses and other rewards were taken as stock or stock options.)
I’ll have to re-read the book again to get my head round some of the ‘investment’ vehicles decribed. Small wonder that many misunderstood them.
Ratings agencies , who exercise enormous power while lacking understanding, also come very badly out of this book.

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